The Corporate Observer Blog : Consumer Protection, Corporate Abuse : Class Action Lawyer & Attorney : Steven Berk Law Firm

At least once a week a new report comes out detailing inadequacies or improprieties by one or more of the companies involved in the housing bubble and financial crisis...  While we read the reports and follow the news, the foreclosures continue, along with the unregulated credit ratings, robo-signings, and predatory lending.  Nothing material about our current practices has changed.

If you listen to candidates for President, regulation is the greatest threat to our democracy.  (Actually it's never just regulation it's overregulation.)  The Chinese owning our debt and growing at five times our rate… nahhh; Al Qaeda gaining nuclear weapons?  Nope.  Okay… steadily declining scores in math and science for high school students?  No, sorry.  It’s regulation.  We need less regulation, more democracy, and more prosperity.  Or maybe just no regulation, absolute democracy, and absolute prosperity.  Hmmmmm...  Can it be that easy?

No.  It's time to look at the facts.  At least once a week a new report comes out detailing inadequacies or improprieties by one or more of the companies involved in the housing bubble and financial crisis.  On Monday we learn Standard and Poor’s refused to downgrade AAA-rated companies despite damning evidence.  By Friday, we’ve forgotten S&P because news surfaces that banks had robo-signers executing their foreclosure agreements.  And early the following week, the focus shifts back to S&P as U.S. credit is downgraded and the DOJ brings suit against the credit rating agency.  Yesterday, as TCO hero Gretchen Morgenson reports, the FHFA released a report detailing the timeline of Fannie Mae’s discovery of abuses by the teams of law firms assigned to oversee foreclosures.

The takeaway: Fannie was aware early of its lawyers improprieties. Shocking.

While we read the reports and follow the news, the foreclosures continue, along with the unregulated credit ratings, robo-signings, and predatory lending.  Nothing material about our current practices has changed.  Dodd-Frank hit an impenetrable political wall and credit rating agencies have indemnified themselves by declaring their ratings “mere opinions”.  The Boston Globe reporting that “Alex Rodriguez is an overrated ball player” is afforded the same protection as credit agencies saying “U.S. credit is no longer the safest investment you can make.”

So while it is important to assess our past failures, at this point we must take the next step. We need substantially more oversight.

Here are a few modest proposals:

• Call the CRAs what they are—oligopolistic pseudo-government agencies—and establish straightforward accountability standards for the ratings they produce.
• Separate investment banking and “plain old banking”, as the venerable Paul Volcker has called for.  This limits the risk to which regular banks are exposed and allows them to engage in simple money storage and loans.
• Limit corporate compensation at institutions that have required infusions of taxpayer money, and require better disclosures to the public as to the risks taken and compensation awarded.
• Most importantly: Actually empower the agencies charged with regulating the industries with the authority and resources to do so.

Now that would truly be news.

Assisted by David Martin

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When Standard & Poor’s downgraded U.S. credit, I wrote in these pages that it had done a disservice to the American economy and consumers.  Far from providing a true barometer of the risk associated with U.S. debt, S&P was “paying back” for missing the most flagrant foul of the century: Providing Triple A ratings for sub-prime mortgage securities.

Fast forward four years to today and S&P misguided effort to get it “right” by downgrading US debt.  S&P was alone and wrong to do so.  Its sudden lurch to “overprotective, overcautious rating agency” was a cue followed by no one; yet it led to the worst single-day Dow Jones drop since 2008.  (And trust me, with an election year nearly upon us, we haven’t heard the last of this historic downgrade.)

Now comes the SEC, with its whistle and a big yellow flag flying. “Penalty, S&P.  Frivolous granting of a AAA rating to a basket of questionable mortgage backed securities issued in 2007.  Fifteen yards and an automatic first down.”

Given the timing of the SEC action (on the heels of S&P's decision to downgrade US debt) its motivation may be suspect, but the Commission is surely moving in the right direction.  The Credit Rating Agencies must be subject to greater regulation.  While the SEC is looking into S&P actions leading up to the financial crisis, they must continue to prosecute where they can and with rigor and purpose.

We can only hope this current probe into S&P will lead to a wider investigation, in which the entire structure and dependence on CRAs is evaluated.  Major repair is needed in any system in which an agency is paid by the very company it is rating to issue an “unbiased opinion”.  But first the SEC must add some bite to its bark by imposing real penalties on S&P’s. We’ll see.

Consider me among the skeptics. 

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Standard and Poor’s announced it has sacked former CEO Deven Sharma in favor of Doug Peterson, former Citigroup Chief Operating Officer.  (Click here for the WSJ story.)  We can’t say we’re shocked.  Under Mr. Sharma’s watch, S&P recklessly approved a downgrading of the US Debt from AAA to AA+.  Although the bond market professionals have largely ignored (as have China and other major holders of trillions in bonds) the action is sure to infect the political atmosphere beyond repair.  Get ready for months of the following rhetoric:

“President Obama has destroyed the credit rating of the United States through his failed economic policies and his inability to control government spending by raising the debt ceiling,” cried Michelle Bachmann.

“Record debt and the President’s refusal to control spending led to our nation’s credit rating being downgraded for the first time in history,” exclaims Rick Perry’s first political campaign spot.

The downgrade is a result of a “failure of leadership” according to Mitt Romney.

No it’s the arrogance, hypocrisy and negligence of Standard and Poor’s.  The downgrade is brought to you by the same rating agency that gave Lehman brothers a AAA rating just a month before its collapse and sought to make a splash with its downgrading of the US debt.  Timothy Geithner says S&P demonstrated a clear lack of understanding of the US economy.  Given S&P is the only agency to downgrade the US debt, the wisdom of the decision is certainly in question.

If S&P is looking for a new leader to run a profitable business, Doug Peterson, formerly of Citigroup, is surely up to the task.  However, if Standard and Poor’s is looking to restore its tarnished reputation, Sisyphus is more likely the man for the job.

Assisted by Zachary Kady

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Several years back the credit rating agencies became virtually immune from lawsuits as they cleverly maintained—and the courts agreed—they were merely expressing their First Amendment “opinion” on the bona fides of a bond offering.  Think consumer reports rating power drills or your local newspaper film critic telling you Caddyshack 2 is better than the original.  Forget that billions were invested in the bonds they rated or the huge fees they received from issuers.  They could only be successfully sued—like a magazine or newspaper—if you could establish “reckless disregard for the truth.”

Is a mistake of $2 trillion reckless enough?  Yes, trillion with a “t”.  That’s the amount that S&P was off in its basic budget calculation.  Shortly after being advised on Sunday of the mistake by administration officials, they went ahead anyway with their “opinion” to downgrade US debt for the first time in history.  That decision was merely emblematic of a string of “reckless” conduct.  These are the same guys who fueled the subprime mortgage crisis by not flinching from an “opinion” that mortgage-backed securities—often backed by mortgages with no documents—were investment-grade.  AAA-rated.  Or Lehman Brothers bonds, which remained A-rated on the verge of bankruptcy as its business rapidly became exposed as a house of cards.

To be sure, Sleazy & Poor Judgment’s “opinions” on the vitality of corporate and government debt offerings have been… well… downgraded by the market.  And there is no doubt a crisis in Washington regarding issues of spending and debt, irrespective of the actions of S&P.  But regrettably an S&P opinion still holds sway.  In the short term it will wreak havoc on the stock and bond markets; yesterday the Dow Jones plunged over 630 points, the worst drop since 2008.  Over time it will fester and linger, well into and through November when both parties try to blame the other for this “black eye” to the pride of America.

Back to the lawsuit.  S&P should be called to answer for its decision to go full-steam ahead toward the downgrade even though their supporting calculations were $2 trillion off.   A lawsuit cannot solve the financial mess we are in, but it can sideline a voice that has done a disservice to the American People.

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Pop Quiz: Who has the most influence over the world’s financial markets?

Tim Geithner, Ben Bernanke, our beloved Elizabeth Warren, new kid on the block, IMF Chief, Christine Lagarde, or Goldman Sach CEO Lloyd Blankfein?

Answer: None of the above.

The Answer: Raymond McDaniel and Deven Sharma...  ...  Wait, who?

McDaniel and Sharma, CEO’s respectively of Moody’s and Standard & Poor's.  Remember not long after they lost all credibility by time and again pulling those green eye shades over their eyes, holding their noses and giving every subprime, no-document, securitized mortgage bond fund a rating of investment grade.  Yep.  Brought us to the brink, to the edge; and although there was some talk of “clipping their wings” in the halls of Congress, it is too late now.   They are back and even more powerful.  But this time they are singing a new tune.  Despite cries of foul and fear their now conservative practices will cause another financial apocolypse, they will not stand down.  Look at what they are doing in Europe; the credit rating agencies (“CRAs”) face intense international pressure over their “junk” ratings of Greek, Portuguese and Irish debt, yet they steadfastly refuse to back down.

Now they seem to have their sights on the U.S. Debt as they threaten to downgrade trillions of dollars in Treasury bonds to below AAA.  Forget Congress, these are the guys to watch.  They scare me, they are too powerful, and a little bit sinister.  How can we trust their insistence on downgrading debt when just a couple of years ago they would have presumably graded a fistful of discarded “Powerball” tickets AAA. I’m not being paranoid, am I?

I say Congress should move forward with hearings before these CRAs push us once again to the brink, because I fear this time, we are going over the edge. 

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Pull a Madoff -- in that the Commission will miss the shenanigans that are right underneath their noses, just as they did with Bernie years ago.

Yesterday the SEC announced a proposed set of regulations that would curb some of the abuses of the rating agencies (Moody's Corp. (MCO), Standard & Poor's, a McGraw-Hill Cos. (MHP) subsidiary, and Fitch Ratings).

First, let’s talk about the basic problem.  The issuer of debt pays for the rating.  It’s a naked conflict of interest.  Here’s an oversimplified example.  Bank of America has a bunch of sub-prime mortgages it securitizes in a bond offering it wants to offer for sale to pension funds, university endowments, charitable trusts and the like.  They need an Aaa rating or something close to it; it is called investment grade, since many institutions cannot invest in anything lower.

They go to Moody’s where they’ve had some luck before (wink, nod).  Moody’s, being a bit “moody” after all the bad publicity post-2008 disaster, says: “You know BofA there is a lot of risk in these underlying bonds (“really”).  Sorry, best we can do is Ba1.”

Bank of America, undaunted, and knowing how to play the game, comes back with: “Come on guys, how ‘bout if we sweeten the deal a little and increase your fee... and we’ll throw in some Legend Seats at Yankee stadium.”

“Against the Red Sox?”

“Fine, against the Red Sox.”

“You know those bonds are looking more Aaa every day,” says the Moody analyst, as he pulls his favorite Red Sox cap off the shelf.  It’s a conflict of interest at its simplest.  And guess what, if a BofA bondholder wants to sue the rating agencies after the bonds default, good luck.  The rating agencies have a “get out of jail card” at the ready.  “We were merely exercising our First Amendment right to render an opinion.”  Wins every time in court.

Second major problem: the Revolving Door.  That same Moody’s analyst who loves the Red Sox and will see them up close on BofA’s dime has already sent her resume to Bank of America and hopes to enjoy a 100% salary increase when she takes a job as a newly minted Vice President in the debt securities division.

Dodd-Frank provides the SEC with new authority to fix these conflicts.  What is the Commission doing?  A little window-dressing is all, nothing more.  For instance, the SEC has suggested rules that would have rating agencies clearly define and disclose the meaning of any symbols used by the rating agency.  The proposed rules attempt to directly address conflict of interest issues, but half of the section is devoted to exemptions and exceptions.  It is also seeking to set up qualification standards for credit analysts, to make sure they meet new training and experience standards.  Ho hum.  And indeed, the rating agencies are fighting even these minor reforms.

What the SEC must put on the front burner instead is the organization of a government-mandated clearinghouse intermediary through which credit raters would be assigned blindly to work on various bond offerings.  (No more Legend Seats.)  This intermediary was called for in Dodd-Frank and is being pushed for by Senator Franken.  Alas, in the way of Washington, the SEC will study the issue and issue a report, next—yes next—summer.

I can see the headlines a year in advance: SEC Misses Trillion Dollar Losses Caused by Continued Rating Agency Conflicts.

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Just like so-called “amateurism” in college athletics, the “unbiased, mere opinions” bestowed by credit rating agencies are largely a façade.

Often what we say is different from what we do.  Day-to-day life provides us plenty of examples: “amateurism” in college athletics, the “reality” of reality shows, and Fox News’ “unbiased” political coverage being just a few that come to mind.  Yesterday, Second Circuit U.S. Court of Appeals Judge Reena Raggi fell victim to a lesser-known fallacy: the “mere opinions” of the credit rating agencies (CRAs).

In her decision handed down yesterday, Judge Raggi gave rating agencies such as Moody’s and Standard & Poor’s a huge victory.  She did so by agreeing with the agencies that they offer “mere opinions” on the solvency of an institution’s debt.  Hmmm...  So Moody’s is no different than “Consumer Reports" or Zagat’s?  Who knew?

Just like so-called “amateurism” in college athletics, the “unbiased, mere opinions” bestowed by CRAs are largely a façade.  Debt-issuers pay these agencies to rate their creditworthiness (yes, you read that right—they are paid by the very same people that they supposedly objectively rate); the interest rate on any debt is intimately tied to this rating.  In other words, the securities market could not function without these CRAs.

Do you think Fannie Mae would have enthusiastically paid Moody’s to rate its credit if Moody’s raters had thoroughly investigated the bundles of subprime debt amassed by Fannie?  Hey Fannie, thanks for the payment, but we’ve determined that without Federal Government takeover you will be unable to repay your loans…  Here’s your D rating.  What’s more: the ratings agencies are integral to the proper functionality of the market.  Without ratings there would be next-to-nothing on which to assume risk or base interest rates.

Although credit rating agencies serve as de facto underwriters for the debt instruments they rate, Judge Raggi relies upon the 2nd Circuit Decision in SEC v. Kern to distinguish their conduct from “those who take ‘steps necessary to the distribution’ of securities”.  That "distinction" is a complete fiction.  Of course CRAs are necessary to the markets.  Indeed, without them there would be no debt market.

Forget the law?  How convenient.  Chalk up another one (on an ever-growing chalkboard) for big business and the financial industry.  Don't blink, next thing you know “insider trading” may well be regarded as a proper mechanism for distributing risk.

Assisted by David Martin

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Memories are short in Washington and even shorter on Wall Street.  Temporary becomes permanent, and the petulance and arrogance of the rating agencies is soon forgotten.

I was disturbed to read this weekend in another fine piece by Gretchen Morgenson how yet again the rating agencies (Standard and Poor's and Moody's and the like) had obtained another “Get Out of Jail Free Card.”  For decades they avoided liability from their negligence (or worse: stark conflicts of interest with issuing banks), by cleverly claiming their grades given to investment securities (AAA and on down) were opinions to be afforded First Amendment—as in the United States Constitution—protection.  Well, they got away with it until the financial crisis of 2008, when hundreds of billions in mortgage-backed securities with investment-grade ratings were determined to be just about worthless.

Congress responded to this historic immunity nonsense in Dodd-Frank by explicitly requiring that the ratings agencies be subject to expert liability, opening up for the first time liability from investor lawsuits.  How did the ratings agencies respond?  Like a petulant child by refusing to rate asset-backed securities.

Rescuing the rating agencies from the “time out” they deserved, the SEC gave them a free pass.  First temporary, now permanent; a “no action letter” was granted providing agencies with an absolute defense to investor lawsuits.  Last week, Martha Coakely, the Massachusetts Attorney General, in a letter to Mary Shapiro, Chairman of the SEC, wants to know, “Why?”

The party-line, spewed by co-author of the legislation, Barney Frank: this is merely a short-term strategy to wean the markets from reliance altogether from the influence of ratings agencies, we’re just not there yet.

Sadly, this won’t work.  Memories are short in Washington and even shorter on Wall Street.  Temporary becomes permanent, and the petulance and arrogance of the rating agencies is soon forgotten.  I hope General Coakley fights hard for answers and doesn’t back down—this no action response of the SEC is unacceptable.

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If Mr. Kroll and his son can remain free from conflicts his venture has a shot at adding value to this deservedly beleaguered market.  We wish him luck.

As reported by Janet Morrissey in the New York Times yesterday, Jules Kroll hopes to create another seismic shift in the business world.  First it was bringing “cloak and dagger” style investigative tools to businesses in an upfront and relatively transparent manner.  No easy trick.  But he pulled it off and spawned a multi-billion dollar industry.  No Fortune 500 company today makes a major move without gathering “business intelligence”.  Now, he wants to add this same methodology to the “green eye shade” accounting world of credit rating agencies, i.e. Moody’s and Standard & Poor's.

The old school approach was to look at the numbers. Dispassionately, objectively and without fear or favor.  A trillion dollars in losses later, and that model seems inextribably broken.  Indeed, Warren Buffet and other major investors have been proclaiming the death of the “rating agency model”.  And who could blame them – these supposed paragons of analysis and near divine insight rated trillions of dollars of sub-prime bonds – in the end worthless bonds – investment grade; a stamp of approval required before pension funds and other institutional investors.  Heck these guys rated Lehman’s paper investment grade, days before its bankruptcy.

Mr. Kroll, as always part showman, part genius, says he “will be looking under the covers” in addition to the numbers.  That should be interesting (think Mark Hurd of HP and other corporate titans brought down by sex scandals).  But the key will not be what happens under the covers.  No, the key is independence.  If Mr. Kroll and his son can remain free from conflicts his venture has a shot at adding value to this deservedly beleaguered market.

We wish him luck. 

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We have become dependent on the accuracy of the ratings, and yet the agencies that issue them are unregulated and are far from objective… Clearly we cannot continue at status quo.

 

Three cheers: to James Surowiecki of the New Yorker

In protecting Main Street, it is rare that I give banks and regulators a break. However, given the lack of attention to another guilty branch of the financial sector, they are going to get a brief (if undeserved) reprieve from me. The other blameworthy party that I speak of is the credit ratings agencies. Let me explain.

Credit rating agencies assess and label the riskiness of financial instruments (AAA being the best). As this recent New Yorker piece by James Surowiecki details, a problem arises because the rating agencies are privately owned and yet the S.E.C. anointed three of them as official ratings agencies—thus instilling a special trust in them by investors. And that was forty years ago. Today everything—from rules and regulations on financial instruments to interest rates—depends on these ratings.

So what happens when these agencies drastically overestimate the soundness of mortgage-backed securities? In part, that is what caused our current economic situation. The article explains the problem: we have become dependent on the accuracy of the ratings, and yet the agencies that issue them are unregulated and are far from objective. I must commend Mr. Surowiecki for this insight. When the agencies gave mortgage-backed securities a rating of AAA, investment flooded to them, creating the all-too-famous housing bubble. When, in light of the housing crash, the agencies harshly downgraded the securities, it drastically accelerated the bursting of the bubble.

Clearly we cannot continue at status quo. As in other under-regulated fields, Main Street became the victim of overzealous and unchecked standards. What can we do about these agencies? The New Yorker suggests scrapping the ratings agencies altogether, reasoning that no faith is better than false faith. I don’t know if that is the answer—it would be preferable to merely disconnect the ratings agencies from governmental endorsement—but clearly Main Street must be spoken for here as well. Hopefully my voice on this issue will couple with the Mr. Surowiecki of the New Yorker to be the first of many to advocate sweeping reform.

Assisted by David Martin.

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